Are India's laws weakening the right of creditors?
It has been long established that legal systems affect financial development in a country. The strength of creditor rights indicates the protection lenders have if a borrower becomes insolvent. When lenders can enforce repayments more easily, access collateral, or gain control of the firm in case of default, they are more willing to extend credit. Another significant thing that matters for lenders is information. When lenders know more about borrowers, they are more willing to extend credit. When the information is scarce, there arises a problem of information asymmetry.
First, there is ex-ante information asymmetry or adverse selection which refers to the fact that borrowers have more information about themselves than lenders. This makes it difficult for lenders to distinguish between good and bad borrowers, resulting in a situation where lenders are excessively prudent while lending. Second, there is ex-post information asymmetry or moral hazard, which occurs after lending, wherein borrowers indulge in excessive risk taking in presence of debt financing. Both lead to lower availability and higher cost of credit in a financial system.
Creditor Rights and Information Environment in India
India’s tryst with creditor rights and information environment has been complex and ever-changing. For a long time after Independence, the winding up or liquidation of companies was catered to by the provisions of Companies Act, 1956. It was in 1985 for the first time that a key piece of legislation – the Sick Industrial Companies Act (SICA) – was brought to deal with the issue of rampant sickness of industrial companies.
The first major change in creditor rights or bankruptcy laws was brought in through The Recovery of Debts Due to Banks and Financial institutions (RDDBFI) Act, 1993 under which special debt recovery tribunals (DRTs) were set up wherein cases regarding bankruptcy could be dealt with in a swift and specialised manner instead of lengthy court proceedings.
Even after setting up tribunals, the liquidation or rehabilitation proceedings could take 10-15 years. As a result, assets would often be misappropriated, transferred, or just devalued over the course of proceedings, leading to significantly lower secured credit recovery.
The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 ushered in a new era of creditor rights by allowing secured creditors to bypass the lengthy court process and seize the assets of the defaulting firm. During all this time, not much emphasis was given to information environment and any credit information-sharing mechanisms in India were virtually non-existent. It was only in 2005 that the Credit Information Companies (Regulation) Act (CICRA) came into place and mandated all lenders to report their borrowers’ credit information such as payment history, defaults etc to credit bureaus such as CIBIL.
The creditor rights and information environment continue to evolve with the recent Insolvency and Bankruptcy Code (IBC), 2016 in addition to the Reserve Bank of India (RBI) on the verge of setting up a public credit registry. We chose The SARFAESI Act, 2002 as a unique point with weak credit information environment and strong creditor rights to examine if stronger creditor rights by themselves could mitigate the problems of information asymmetry.
The Differential Effect of Creditor Rights on Unlisted and Listed Firms
Majority of the research over the last two decades has shown favourable effect of creditor rights on credit supply and the cost of credit, although some studies have also documented unfavorable effects mostly arising out of demand problems wherein borrowers’ fear of premature liquidation overpowers the increased supply of credit due to stronger creditor rights. A key unresolved issue in the creditor rights literature is the differential effects of these rights on financial constrained and informational opaque borrowers. We use unlisted firms i.e firms that are not listed on BSE or NSE as a proxy to these factors and examine the differential impact of SARFAESI on these firms as compared to listed firms. Unlisted firms are financially constrained as they have less access to public equity markets and typically to debt markets as well.
Unlisted firms are also informationally opaque as they are not required to report information to stock exchanges, do not have monitoring by public equity holders, and lack public stock price changes to signal information about these firms. The effects of creditor rights on unlisted firms may have greater policy implications because of the inferior access of credit for these firms. We examine a sample of 22,533 non-financial firms across eight years spanning FY 1999-2006. We observe that unlisted firms are significantly smaller in size, have lower secured debt, pay higher interest rates, have lower number of lenders, and are less likely to have a credit rating than listed firms.
The SARFAESI Act strengthened creditor rights primarily by way of improving access to collateral for lenders. We find that good firms amongst unlisted firms were able to get better access to debt, especially secured debt, by way of signalling their quality to lenders through the improved value of collateral as a contractual mechanism post-SARFAESI. The total debt to assets ratio increased by as much as 6.9% and secured debt to assets ratio by 5.5% for unlisted firms post-SARFAESI as compared to listed firms. Borrowing rates decreased overall, but decreased more for unlisted firms.
We further disentangle the role of collateral in mitigating moral hazard and mitigating adverse selection. We find that collateral has a moral hazard reducing role for listed firms and a signalling role in mitigating adverse selection for unlisted firms. We also find that among unlisted firms with fewer lenders, the interest rate spreads narrowed further as compared to similar firms with higher number of lenders indicating a reduction in information rents – the extra interest rate that lenders charge when they monopolised access to information of a borrower. This indicates that SARFAESI also brought about the results that are generally expected of a good credit information sharing mechanism indicating that creditor rights might act as a substitute to information sharing.
Current and Future Policy Implications
These results could have major policy implications especially in the current scenario of IBC, 2016 being implemented as the latest creditor rights mechanism. It is widely believed the IBC is a mechanism that strengthens creditor rights. However, it has been observed that in some cases that IBC has superseded SARFAESI thus weakening the rights of secured creditors. In so far as IBC strengthens credit rights, we can expect favourable effects for financial constrained and informationally opaque firms despite the demand side problems that might occur due to fear of liquidation. It should also be examined whether benefits of setting up a public credit registry (PCR) to improve the information environment outweigh the costs when private credit bureaus (PCBs) already exist aided by stronger creditor rights alleviating information problems. The final implication of our study is that mechanisms such as creditor rights and information sharing that improve overall lending environment shouldn’t be viewed in isolation and their interrelationship should be considered before bringing about any policy changes around them.
(The study has been authored by Pulkit Taluja)